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Master Limited Partnerships

Master limited partnerships, or MLPs, have become big business and more prevalent in investor portfolios over the past couple of years. They provide investor exposure to the growing oil and gas infrastructure of America, and they come with attractive distributions for investors seeking dividend income and capital flows.

Because MLPs do not have to pay corporate taxes, they have more cash available to fund their distributions. To organize as an MLP, a firm must earn 90% of its income from activities related to natural resources, commodities or real estate. Consequently, a number of MLPs are the slow-growth businesses – such as pipelines and storage terminals – that energy companies have spun out over the years. The majority of MLPs' operations are based in North America.

Since the underlying businesses are slow-growth, investors typically wouldn't expect substantial long-term capital appreciation. However, slow growth also equates to stability, which means that MLPs – while traded on the stock market – tend to be less volatile than typical natural resources stocks. One reason for this is that they generally aren't dependant on commodity prices to generate earnings. The problem facing MLPs is the business segment of the oil and gas sector has seen its valuations increase as investors have looked for alternative means of generating income.

Investors can typically earn attractive yields that are well above those available in most areas of either the equity or bond markets. Many dividend-oriented investors seem unclear on what they are buying when MLPs are recommended by a financial advisor. Investors are often sold on the return or “yields” of 5% or more without understanding the downside risk of investing in MLPs.

Historically, MLPs have a low historical correlation with other areas of the market – meaning that they tend to fluctuate in a relatively independent fashion rather than being tied to the performance of the broader market. As a result, financial advisors may recommend a small allocation of MLPs to help reduce the overall volatility of an investors' portfolio.

Investors may indirectly own MLPs in their portfolio and have no awareness of their MLP ownership interest. Certain energy funds and exchange traded funds (ETFs) own either MLP units or their general partners. Many domestic and global infrastructure funds and ETFs also own MLPs or their general partners.

MLP valuations are generally based on the effective yields, even though these distribution “yields” are composed of both income and a tax-advantaged return of capital component. It remains to be seen whether MLPs will suffer with a rise in longer-term Treasury yields and whether MLP investors will head for the exits in light of safer available Treasury yields. Another concern has been that Washington D.C.'s quest to raise taxpayer revenues may eliminate at least some of the tax advantages of MLPs.

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